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| "Fight Between Jacob And The Angel" - Pier Francesco Mazzucchelli (1610- 1620) |
Paul Krugman recently wrote a post explaining how real resources in finance are being devoted to getting an "economic number" before everyone else, taking advantage of asymmetric information. The example Krugman brings is the one where Thomson-Reuters pays the University of Michigan a million dollars a year for early access to the monthly Michigan consumer sentiment survey. In the era of High Frequency Trading (HFT), this of course can be a great advantage over the other market participants. However, this practice is completely legal as explained in this post.
Profiting (illegally) by taking advantage of information asymmetries and insider trading shouldn't sound new to financial insiders. Insider trading is a long-dated illegal activity with the most striking and famous cases concentrated in the stock market (see here, here and here). However, this post will not focus on them. Although stocks are the most heavily traded asset class in insider trading information, there is little to add as these cases are very popular and a lot has been written.
Other financial products which are very vulnerable to information asymmetry will be at the center of discussion in this post. The first and perhaps, most important example are Credit Default Swaps (CDS). A credit default swap is a credit insurance contract that pays a specified payout on default of the underlying asset. Investor A wants to buy protection against a loan it has issued to company Y. Investor A enters a credit default swap on a specific underlying asset with counterpart B. Investor A pays a premium to the provider B of the credit default swap. If the credit event occurs, B has to repay A in full in a pre-specified way (missed coupon, total default, etc.). What makes CDS so vulnerable to asymmetric information is their intrinsic nature and the lack of regulation and oversight. CDS are vulnerable to insider trading for four specific reasons:
- Most of the players in the CDS market are financial institutions and insurance companies (retail investors are largely absent);
- The majority of CDS are held by the same financial institutions and insurance companies that dominate the CDS market;
- CDS are opaque products and only recently they have been tried to be regulated with the Dodd-Frank Act;
- CDS incentives the moral hazard which arises from insider trading information.
As A lends to company Y, A collects several information about Y in order to make sure that company Y will be able to repay the loan. As A wants to buy protection against the default of company Y, it uses the information it has about Y in order to price the credit default swap. The problem with asymmetric information lies in A potentially exploiting the information it has gathered from Y and then indirectly transmitting it to the public markets. As an example, A is aware that company Y is not in a good shape (financially speaking) and may exploit the information it has at the expenses of the sellers of the CDS protection. Company A may profit by betraying company Y and potentially destroying its client with the insider information it has. And here is another problem with CDS: the non-public information which lies within the borrower and the lender.
As for today, the only case of insider trading on CDS we have seen is the one between Deutsche Bank (DB) and the hedge fund Millennium Partners. A bond trader at DB, Mr. Rorechat passed insider information to Mr. Negrin (portfolio manager at Millennium) about a Dutch company that DB was supervising, VNU. The insider information was about a change in the bond offering at VNU. Mr. Negrin consequently bought CDS on VNU’s bonds that increased their value by $1.2 million. I also want to emphasize that whoever has insider trading information on macro news (like the example given by Paul Krugman) may use CDS indices to profit instead of trading on the stock market. Why? For the same reasons I mentioned above: lack of transparency and regulation and because it’s easier to get caught in the stock market. There are in fact several CDS indices which are suitable for that trade. And of course, the same applies to companies. Whoever holds insider trading information can profit by betting against it on specific tranches of CDS indices based on companies.
Another good example of securities vulnerable to information asymmetry can be found in structured finance. The infamous CDO (Collateralized Debt Obligation) called "ABACUS 2007-AC1" issued by Goldman Sachs in 2007 is probably the best case in point (for a brief explanation on how a CDO is created, packed and sold, please see here). The CDO was put together by John Paulson and made of the worst possible assets at that time (adjustable rate mortgages, low borrower FICO scores, mortgages in states that had experienced high rates of home price appreciation such as Arizona, California, Florida and Nevada). John Paulson was rightly betting on the collapse of the housing market in 2007. Paulson's goal was to profit by betting against ABACUS by using Credit Default Swaps (see how the moral hazard arises from the asymmetric information?). However, GS failed to disclose to its investors how the portfolio underlying the CDO was put together. Investors were unconsciously underestimating the risk they were taking. After all, "the two main indicators of risk available to investors -- credit ratings and the role of the collateral manager -- were both misleading". They thought the portfolio was made of 90 bonds derived from subprime mortgage loans. In one year, the 99% of assets underlying ABACUS defaulted and Paulson personally made $1 billion out of the deal. Even in this case, it should be pretty evident that the seller-side of these products are privileged as they have an asymmetric information advantage over the buy-side. Furthermore, buyers are not in a position to carefully examine how good the investment is or regularly check how it is doing as loan-level disclosure reports are due once per month or even less (while the sell-side gets information on the loan-level performances on a daily basis).
And of course there are then the numerous cases of market manipulations such as the LIBOR, High-Frequency Trading in equities market, in the swap market (IsdaFix) and recently in the FX market too. But maybe that's the topic for another post...
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* The above panting represents the eternal conflict between good and evil (with no allusion from my side)
Your examples are true, and I'm sure useful to folks who are new to this stuff, but, what, really, is your point?
ReplyDeleteK's point was the semi-last sentence: "[T]hese days many vast fortunes come, not from building something, but from consistently guessing what other investors are going to do a few days, or sometimes a second or two, ahead of the pack."
Clear, no?
Are you saying K should have talked about CDS and how crazy that whole world is?
Just wondering. Thanks.
I focused only on the first part of Krugman's article on my post.
ReplyDeleteKrugman begins his analysis bringing an example of asymmetric information. I elaborated it a little bit, bringing examples of asymmetric information in the CDOs market and insider trading in CDS.